Private debt is a potential solution for institutional investors confronting low yields, heightened market volatility and rising interest rates. Investors are turning to alternative credit in search of high current income, low correlations with public markets and lower default risk than yield spreads would imply. Senior leveraged loans to middle market companies, in particular, are among the fastest growing private debt alternatives as banks curtail their exposure to middle market borrowers. With floating-rate structures, leveraged loans offer the potential for increasing income with less price sensitivity as interest rates normalize.

Nonetheless, institutional investors remain underinvested in private debt because they lack familiarity with its attractive risk-return profile compared to traditional fixed-income assets. Powerful trends are driving demand for private debt overall, and middle market senior loans in particular. First, pension plans and insurance companies are struggling to achieve targeted rates of return amid historically low yields on traditional fixed-income investments. Their capacity to increase risk in search of returns is limited by their liabilities and, for insurance companies, by capital requirements. Second, structural changes in bond markets, including decreased liquidity and rising asset correlations, are changing how investors think about liquidity and risk. Long-term investors who can buy and hold are more willing to trade liquidity for higher yield — the “illiquidity premium” — and lower volatility to improve asset-liability matching. There is also willingness to increase exposure to sub-investment grade private debt with strong covenants and other protections that help to reduce default and loss rates. Third, banks have curtailed lending to middle market companies following decades of consolidation in the sector and in response to higher capital charges for middle market loans. The middle market — generating nearly $14 trillion in combined revenue or about a third of U.S. private-sector GDP1 — needs ready access to capital for growth, leveraged buyouts and other uses. Non-bank asset managers are filling the void with direct senior loans to middle market companies that have offered investors both higher yield and lower default risk in exchange for illiquidity.

Private debt offers attractive risk and return characteristics Private Debt’s track record of better risk-adjusted returns — and the range of yield and risk characteristics across different categories — make it an attractive alternative to traditional fixed-income and equity investments. Potential advantages include:

Yields significantly higher than offered by similarly rated public debt to compensate for illiquidity

Lower default and loss rates historically, compared with public high-yield bonds due to strong covenants, management oversight and other safeguards

Diversification benefits based on generally low correlations with traditional assets